Rio Tinto's Future Depends On Iron Ore Fate

Jan. 5.14 | About: Rio Tinto (RIO)

Rio Tinto (NYSE:RIO) is bullish about iron ore demand in China, which imports around 70% of the seaborne iron ore. To meet this demand, the company is increasing its production. It will increase its production capacity to 290 million metric tons by the first half of 2014 from 260 million metric tons currently, and will add another 40 million metric tons by 2015.

Other Australian miners -- BHP Billiton (NYSE:BHP), and Fortescue Metals Group Limited (OTCQX:FSUGY) are also increasing iron-ore production. BHP expects to produce 212 million metric tons next year and is clearing bottlenecks to raise its export capacity to 270 million metric tons. Fortescue is projecting to produce at a rate of 155 million metric tons per annum by March 2014. Along with these Australian miners, Vale SA (NYSE:VALE) will increase its production by 50% by 2018.

Because of the increase in global supply, iron-ore prices are expected to decline in 2014, which will affect Rio's margin. Presently the company's cash cost to delivery, is about $47 per metric ton of iron ore. Since the spot price is currently about $134 per metric ton, it is earning roughly $87 per metric ton without deduction of non-cash expenses and other off-site costs. The expected price range for 2014 is $100 to $120 per metric ton. Hence, the company's margin is expected to fall below $70 per metric ton, which is about 20% below the current level. Iron ore accounts for 78% of Rio's EBITDA. Therefore, reduction in margin will significantly affect its overall earning.

Why is the company still increasing the capacity?

Most of Rio's additional supply will be produced from its existing mines, and it has deferred plans for developing any new mines. Doing so, the company will spend $3 billion less than its previous estimation.

Despite the price decline, the company will still realize good margins due to its low cash cost. Also, in case the prices fall from the current levels, then imports in China will increase. Most of China's domestic production is done at a higher cost. Some mines in China are producing at $170 per metric ton. Therefore, if the price falls it will not be cost-effective for these mines to produce. The company is expecting a reduction of about 80 million metric tons of domestic supply. Rio is also planning to start supplying smaller steel mills, whereas it now supplies only large mills. Therefore, I think Rio still has extra room to sell the excess capacity.

Cost-cutting remains a priority

Rio Tinto's debt of $22 billion is a concern, and the company wants to bring it to a more comfortable level, which could give it flexibility for future acquisitions or other investments. Rio intends to its lower debt by $15 billion to $16 billion by 2015. After meeting its debt target, the company plans to return surplus cash to investors. Analysts predict Rio can generate about $3 billion of surplus cash in 2016, which it could distribute either by special dividend or through share buyback.

To repay debt, Rio has reduced its capital expenditure budget to $11 billion in 2014 from $14 billion in 2013, and it will further reduce it to $8 billion in 2015. Rio is suspending some of its coal, aluminum, and industrial minerals projects. Along with Capex, the company is also improving its operating cash cost, having done so by about $2 billion in 2013, and it is trying to cut cost by another $3 billion in 2014. Most of the spending cuts will be in the aluminum division. The company has already planned to shut down its Gove alumina refinery in Australia's Northern Territory, because it is losing money due to falling global aluminum prices. The production suspension will start in the first quarter of 2014 and be completely phased in during the year. Overall, Rio is planning to cut its aluminum division's cost by $1 billion by the end of 2014.

Considering its cost-cutting measures, I expect Rio will meet its debt target and generate surplus cash as well.

Conclusion

Rio Tinto is improving its cost structure. In 2013, its operating cash cost improved by about $2 billion, and the company is trying to improve it further in 2014. The company's major concern, however, is uncertainty about future iron-ore prices, a major contributor to earnings. At present, the price of iron ore is higher than it is expected to be in the near future because of the anticipated increase in global supply. The expected price fall will lower earnings. However, the company is confident it can sell the excess capacity, but still there is uncertainty around it.

Considering all factors, I recommend investors watch the trend for iron-ore prices over the next several months and hold their position during that time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.